The Fed considered the old policy prescription suggested first by Walter Bagehot, a nineteenth century economist and journalist. In his opinion, central banks should lend to solvent banks in large quantities but with a penalty in times of financial market turbulence. The Fed lowered the discount rate and was standing by to lend in abundant quantities. Typically, the Fed uses the federal funds rate or the policy rate to signal changes in monetary policy in order to maintain price stability and economic growth.

Banks borrow from each other at the federal funds rate, which is lower than the discount rate. By cutting the discount rate the Fed invited banks to borrow money without stigma attached to it because discount window borrowing is seen as a financial institution’s weakness. The Fed hopes banks in turn will expand credit for legitimate purposes and the credit markets will resume oiling the economy. The federal funds rate target was left untouched because the Fed sees the current problem as a temporary liquidity problem. At the same time, it took a precautionary step and announced a warning that “risks to economic growth have risen appreciably.”

What is likely to follow after this move?

There is uncertainty in markets now and there is a potential for this to become a full-blown crisis. On the positive side, signs of market strain seem to be moving in the desired direction. For the Fed to declare an all-clear, the panic aspect of the liquidity and credit crunch should be eliminated from market interest-rate spreads and they should reflect risks that are integral to the instrument in question. It is impossible to pin down when precisely the liquidity squeeze will vanish.

The Fed faces a dilemma now because bailing out faltering institutions may encourage irresponsible business practices. At the same time, intervention is needed to prevent an economic disaster. The Fed is walking a tight rope in maintaining economic stability and discouraging reckless financial investments. It is trying to defuse the problem by using the discount rate tool. Will it succeed? One has to wait and watch.

The US economy has grown at 2 per cent in the first half of 2007, with expectations of weaker growth in the second half. The weak economy status allows the Fed little room to make mistakes. It is too soon to judge the credit and money market reactions and aver if the discount rate cut has worked. In the meantime, a string of economic reports such as home sales, auto sales, jobs, and manufacturing sector surveys in the next two weeks should offer insights about the underlying fundamentals of the economy.

It is likely the Fed will wait until the next policy meeting on September 18 to decide the federal funds rate. It is also possible it will be forced to act sooner if markets deteriorate. The dollar is the wild card that may place the Fed in a tight corner — of weighing what is more important, the economy or the currency. Now, the dollar has posted some gains vis-À-vis the euro, but fell back relative to the pound, while the yen continues to strengthen.

What about the impact of all this in India?

There is a school of thought, supported by the IMF, that the rest of the world can pull the world economic engine despite the likely slowdown in the US. Current economic data from Europe and Asia support this view. The Fed presented an optimistic outlook for the US economy as recently as August 7 but has now changed its prediction. The housing market slowdown has escalated into a liquidity crisis of global proportion.

I believe that the US economic growth during the rest of 2007 will be lower and led by weakness in consumer spending. Going forward, a consumption-led slowdown in the US economy should have an impact on its trading partners.

The Indian economy has grown at more than 9 per cent in 2005-2006 and projections indicate robust performance in the coming years. India’s exports may record a decline if the US slows down. In 2006, roughly 18 per cent of India’s exports — about 15 per cent of India’s GDP — was directed to the US. The negative impact can be partly offset by exports of services.

As the US slows down, an effort to reduce costs could boost outsourcing of services. The IT sector has made and will make impressive strides. Possible setbacks from weakness in capital spending in the US may be insignificant.

On the financial side, equity markets have posted losses and are likely to move in tandem with events in the US. The Sensex for instance posted declines in 2001 when the US was in a recession. Institutions in India holding US mortgage-related securities are likely to suffer losses. On the credit side, the Indian corporate sector raised about $15 billion from external sources in the first five months of 2007.

At the extreme, Indian corporations could face higher costs of borrowing through this channel due to increasing credit market spreads. Firms would have to tap into the domestic credit market as an alternative, thereby exerting upward pressure on domestic borrowing costs. This could whittle down the economic growth rate.

These are the possible channels through which the US crisis could affect the Indian economy. Precise estimates of these repercussions would need a more thorough analysis, which is premature given the short life of the crisis. In sum, the spill-over effects of the US financial crisis to the Indian economy may not be significant enough to overwhelm the positive economic momentum already in place.